The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Tuesday, January 22, 2013

BoE's Mervyn King: banks not healthy until private investors willing to fund without central bank support

In his speech at the CBI Northern Ireland mid-winter dinner, Bank of England governor Mervyn King laid out the number one policy to pursue that would complement monetary stimulus was restoring confidence in the banks.

He then described a test for when this confidence had been restored. Confidence had been restored when private investors were willing to "provide them with funds at reasonable spreads over Bank Rate without central bank support".

Regular readers know there is only one way to restore confidence in the banks: transparency.

Specifically, requiring the banks to provide all the useful, relevant information in an appropriate, timely manner so that market participants can independently assess this information and make a fully informed decision.

Confidence in the banks will flow from the independent analysis by market participants because market participants trust their own analysis.

Since the beginning of the financial crisis, market participants have learned their lesson not to trust the financial regulators when they give the all clear signal about the level of risk at the banks. First, the regulators missed the problems the banks faced leading up to the crisis. Second, the regulators have repeatedly missed problems when they conduct stress tests and pronounce banks well capitalized that subsequently need to be bailed out or nationalized.

For banks, all the useful, relevant information that needs to be disclosed on an ongoing basis consists of their global asset, liability and off-balance sheet exposure details.

It is only with this information that market participants can independently assess the risk and solvency of each bank. Market participants use their assessment to adjust both the price and amount of their exposure to each bank.

An example I frequently use for why ultra transparency is needed is the interbank lending market. Currently, it is frozen as banks with deposits to lend cannot assess either the risk or solvency of banks looking to borrow. With ultra transparency, banks with deposits to lend can make this assessment and subsequently lend to the banks looking to borrow.

If restoring confidence in the banks is the number one complementary policy, this can be easily done by simply requiring the banks to provide ultra transparency. A requirement that the BoE can easily implement either through the Financial Policy Committee or its role as the banks' regulator.

So if we cannot rely on monetary stimulus alone, what additional policies should we consider? The right prescription now is a programme that complements monetary stimulus with measures to promote the necessary long-run rebalancing of the economy, enabling us to return eventually to more normal levels of interest rates. Only then can we return to a sustainable growth path. We must not be inactive, but we must be selective in order to be effective.

What are those other policies? They come under three headings: restoring confidence in our banks, reforms to raise the future potential supply of our economy, and changes in the world economy and exchange rates.

Much has already been done to fix the banking system in this country. And there has been a real improvement in the position of UK banks. Capital ratios have risen, leverage has fallen, liquidity has improved, and bank funding costs have fallen sharply, especially since the announcement of the Funding for Lending Scheme last summer and an improvement in market sentiment towards the euro area.

Banks are now overflowing with liquidity, largely as a result of the enormous increase in central bank reserves held by commercial banks. Yet there remains anxiety in markets about the resilience of UK banks.

Of course there is anxiety about the resilience of the UK banks. These banks are 'black boxes' and nobody knows if they are solvent or not.

What the market does know is that between regulatory forbearance and changes to accounting rules it is highly likely that the banks are hiding large amounts of losses. The fact that the banks are hiding large amounts of losses has been repeatedly confirmed by the banks themselves.

So it is no surprise that the market does not think they are solvent.

Ultimately, the only way to convince the market that the banks are solvent is if the banks provide ultra transparency.

Without ultra transparency, market participants must assume that the banks have something to hide and therefore they should stay away.

That is affecting the terms on which banks can obtain funding and so their ability to lend to the rest of the economy. Some argue that UK banks’ capital ratios compare favourably with many of their continental counterparts. They do, and we should welcome that.

Market participant anxiety about the solvency of the banks does not affect the banks' ability to lend.

The reason this is true is that banks can always sell the loans they make to other financial institutions including banks that are long deposits and are looking for loans, insurance companies and pension funds just to mention a few.

But there is only one simple test of whether UK banks now have sufficient capital. It is whether they can convince investors that it is safe to provide them with funding at reasonable spreads over Bank Rate without central bank support.

As the Financial Policy Committee (FPC) noted in its recent Review, UK banks are still some way from being able to convince the market in this respect.

Until banks provide ultra transparency, they will never be able to convince the market that they are solvent or have sufficient capital.

Regulators ... are now working hard to ensure that banks are making adequate provisions for future losses, the likely costs of regulatory penalties and compensation to customers, and stating the riskiness of their assets in a more prudent way.

This lists highlights just some of the issues that cast doubt on the solvency of the UK's banks.

Conspicuously left off of this list is their manipulation of benchmark interest rates like Libor. Clearly, banks face a sizable liability as every transaction based on the benchmark interest rate has someone who lost as a result of the manipulation.

A lesson from past crises, and also from this one, is that it is important to act now rather than hope that problems will go away of their own accord.

True. Until we have ultra transparency, there is no reason to believe that the banks will act now and recognize their losses. Bankers have an incentive not to recognize their losses as they continue to receive bonuses made possible by delaying the recognition of the losses on and off their balance sheets.

As the FPC said last December, it is likely that banks will be required either to raise more capital or to restructure their businesses or exposures, and the FPC will review the position in March.

There is no single remedy appropriate to all banks.

With proper implementation, there is no reason why the two banks with significant state shareholdings could not largely be back in the private sector within a relatively short period. After all, in the United States banks that received state support are already back in private hands.

Restoring our banking system to full – and transparent – health is only one of the structural changes that will be necessary to rebalance the economy.

Please note that Sir Mervyn King understands that transparency is needed for without it, it is impossible to restore the "banking system to full - and transparent - health".

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.